Secure Act in More Depth

My financial adviser is retirement expert Phil DeMuth PhD author of about 12 books on finance and a contributor to Forbes. Every quarter he dutifully pens a letter keeping the troops under his tutelage informed of developments. I wrote a piece on the secure act last month, but this letter’s content is far more extensive. Be afraid, be very afraid

The SECURE Act: Implications for your Retirement

Accounts and Estate Planning: Sometimes a piece of legislation is so terrible that both parties immediately fall in love with it, and this is the case with the Secure Act. It passed the House with an overwhelming majority and is widely expected to pass the Senate soon. The Secure Act covers all the main retirement vehicles: Traditional IRAs, Roth IRAs, SEP IRAs, Simple IRAs, 401(k)s, 403(b), and 457 plans. The legislation is so important that I want to discuss it in detail. I hope it does not pass, but if it does, you will want to be thinking about how it affects you and how to respond.

Background: The main sponsor of the Secure Act is the insurance industry. They are lobbying hard and have our representatives on speed dial. Why? The Secure Act mandates that an annuity payout be offered as an option in all retirement plans. Insurance companies sold $230,000,000,000 worth of annuities in 2018, and their goal is to sell even more.

Annuitizing your retirement plan assets is a bad idea unless:

 You need all the cash for living expenses (you have no bequest motives)

 You can find an annuity that indexed to CPI-E, the inflation rate facing senior citizens that includes their increasingly expensive medical care

 It is indexed to our rising standard of living

 It has the lowest possible default risk

 It is low-cost

Unfortunately, such an annuity doesn’t exist. Congress eyes your retirement accounts as a giant piggy bank. The mandatory offer of an annuity is a slippery slope that could lead to the mandatory annuitization of all retirement accounts in the future. This would shoehorn the distributions into higher tax brackets, raise revenues, and eliminate the “problem” of the inherited IRA. Best of all, politicians would get to accomplish this without “raising taxes.” But that is a problem for another day.

The issue before us is that the Secure Act would be an estate planning catastrophe for people with large IRAs. It takes the sensible planning done up until now and stands it on its head. What is the problem? The Secure Act eliminates the stretch IRA. The stretch IRA let you leave your retirement accounts to your children or grandchildren or other heirs, who then parcel out the required minimum distributions (RMDs)over their actuarial lifetimes. The payout might be small for a child but would grow over the decades until the inherited IRA would comfortably provide for the child’s retirement. A parent could die with the knowledge that, whatever vicissitudes their children might experience in life, they would have freedom from want in old age. What a wonderful legacy. Congress wants to kill it. In exchange, they plan to let you postpone taking your first required minimum distribution for a year and a half – until age 72.

How it would work: The Secure Act forces non-spouse beneficiaries to pull out all the money from your IRA over ten years. (The original Senate plan was even worse: 5 years). A surviving spouse can pull the money out over his or her actuarial lifetime (or yours, if preferable). A child can pull it out over his or her actuarial lifetime up to age 21 but then must takeout the remainder over ten years. Only beneficiaries who are disabled or fewer than ten years younger than the account owner are exempt from this ten-year pullout rule. If you skip a generation and leave the IRA to your 5-year-old granddaughter, she must take the money out over ten years. Under the Kiddie Tax, it would be taxed at her parent’s rates. Only your children (not your grandchildren) can use the actuarial payouts up to age 21. Before, the best approach was to leave your IRA to your kids or grand-kids and stretch the payout over decades. Now the longest stretch might be with your surviving spouse – who likely will be paying taxes in the higher “filing single” tax bracket.

The bracket jump a surviving spouse experiences can easily go from 12% to 25% or from 24% to 35%, especially as the mandatory payout ratios automatically increase with age. For example, the RMD for a seventy-year-old is 3.7% of the retirement account balance, but for a ninety-year-old, this rises to 8.8%. In most cases, the IRA will eventually pass to adult children. If a million-dollar IRA ends up in the hands of an attorney/daughter, she will have to add $100,000 of annual income on top of her six-figure salary for a decade. As much as half might be swallowed by taxes. The effect is to make more of your IRA subject to higher taxes sooner, as distributions are forced out in bigger chunks that are subject to higher tax rates under our progressive tax code. This is not what the government promised us when we were making all those contributions, but there it is.

By the way, the Secure Act is also a college planning catastrophe for middle-class parents. The temporary but jumbo, highly taxed mandatory distributions from inherited IRAs will make these families spuriously appear high-income on the Free Application for Federal Student Aid, ruining their prospects for need-based financial aid. The ten-year mandatory IRA payout will look like a Christmas goose to colleges. The result is the opposite of what the grandparents intended. The Secure Act lowers the value of retirement plans – perhaps not for the half of the population who pay no Federal income tax – but very possibly for you. Our estate planning options for them have become much more unwieldy.

Using a Trust In the past, many estate attorneys would cut and paste the boilerplate from Natalie Choate’s IRA book to establish trusts that could stretch the IRA distributions, rather than having the IRAs pass directly to human beneficiaries. One appropriate use for a trust might be if you had beneficiaries who were young and you didn’t want, say, your 8-year-old grandson to get unfettered access to a million dollar IRA when he turned 18. What happens under the Secure Act? Since there are no longer any “Required Minimum Distributions,” the trust receives nothing for the first nine years. Then year ten, by law, the IRA must pay out everything. Now the kid turns 18, and suddenly he gets $1,000,000. With a decade of additional compound growth, it might be $2,000,000. All delivered in one year, so most of it is taxed at the highest Federal and state brackets. The money that remains is his to spend. Once again, we have the exact situation the grandparents set up the trust to prevent.

Recommendations: Broadly, there are two kinds of trusts that people use here. One is a conduit trust, where the trust passes through all the income to its beneficiaries every year. The other is a discretionary trust, where the trustee decides what gets paid out to each beneficiary every year. In the example above, we saw the conduit trust makes Johnny a millionaire at age 18. If this were a discretionary trust, the trustee could withhold the distribution. But trust tax rates start at 37% on only $12,500 worth of income, and state taxes are on top of that. We can postpone giving the money to Johnny, but the taxes would be severe. If you want to use a conduit trust, take the money out in equal installments over ten years and try to distribute it over as many beneficiaries as possible (kids, grand-kids) so that no one’s taxes are raised unduly. Most kids up to age 24 will be taxed at their parent’s rates due to the Kiddie Tax. If you are going to use a discretionary trust, convert your traditional IRA to a Roth first. That way the distribution to the trust might be postponed for another ten years while it grows untaxed, and then the tax-free distribution can stay in the trust until the trustee parcels it out. The only further taxes would be on the earnings within the trust until it was distributed to its beneficiaries. These can be mitigated by the use of zero dividend stocks like Berkshire Hathaway. But – if you are considering this Roth IRA approach, then the question arises whether you would be better off taking the money earmarked to pay the taxes on the Roth conversion and using it to buy a universal life insurance policy inside an Irrevocable Life Insurance Trust (ILIT) for the beneficiaries instead. That money is out of your estate no matter what happens to the current $11.4 million estate tax exemption and the proceeds from this ILIT would go tax-free to your heirs, distributed on terms that you set. You can model it both ways – Roth vs. ILIT – to see which seems most economically advantageous.

Using a Charitable Remainder Unit Trust Families with large IRAs and some measure of charitable intent could make a Charitable Remainder Unit Trust (CRUT) the beneficiary of a traditional IRA. This maneuver reconstructs the stretch provisions of the inherited IRA that the Secure Act abolishes. The CRUT needs to file a tax return every year but offers you the flexibility to set it up and invest it yourself. There is no reason why the final charity couldn’t be your family’s donor-advised fund if you so choose (although not your private family foundation). The CRUT sells the IRA assets but does not pay taxes. Your estate receives the amount that will eventually go to charity – 10% at a minimum – as a tax deduction. Meanwhile, the beneficiaries receive, say, 10% of the account balance per year for twenty years. They pay taxes on that as ordinary income. If the CRUT is invested successfully, beneficiaries could even burn through the initial contribution and eventually receive distributions taxed as capital gains. As one attorney told me who is doing this with his own estate, there are plenty of ways to screw it up. There are rules to be carefully followed. Talk it through in advance with your custodian and trustee to make sure everything is in good order – especially the beneficiary forms – so the IRA flows seamlessly to the new CRUT. It will probably work best where the IRA and the CRUT have the same custodian. If you don’t want all this trouble, big charities are happy to let you use the CRUTs they manage if you are willing to leave the remainder to them.

Action Item: A rule of thumb is that you use a trust when you don’t trust. If your beneficiaries can be people (responsible adults who unlikely to be sued) that is always easiest and cheapest since you avoid the expenses of drafting trusts, using trustees, and filing trust tax returns every year while paying trust tax rates. We can change beneficiaries easily by submitting a piece of paper to Fidelity. If your retirement accounts currently name a trust as the beneficiary, you should contact your attorney if/when the Secure Act passes to determine whether the trust as written still achieves your objectives. One red flag would be any mention of “required minimum distributions” or other actuarial-based withdrawals from the IRA in the trust documents. Your trust would have to work with the new ten-year withdrawal rule.

Superb analysis IMHO!

8 Replies to “Secure Act in More Depth”

  1. Thanks for providing your advisor’s analysis, definitely spot on. If some form of SECURE passes one of my first calls will have to be to my estate attorney. My current plan functions as described, using the stretch within a trust to pass to my kids. OUCH! Besides your previous thorough analysis on the benefits of Roth conversion to manage retirement financial risk, we now have another potentially more costly reason to do so. Accelerating a TIRA payout into a 5-10 year window seems like greedy governmental money grab. I’ll be interested in future modeling among the use of Roth vs life insurance vs CRUT. David at FiPhysician most recent post has already started looking at this.

    1. Hey GF Like Phil said it’s a money grab by the government inside of a money grab by insurance companies. As I recall AIG went under in 2009 and would be bankrupt except for too big to fail, MEANING if you were counting on AIG to fund your kids you’d be out of luck except for bailout. The only reason we could do the bailout was we are the reserve currency and could rev up the printing presses by expanding the balance sheet of the FED. It worked but doesn’t mean it will always work. I’m looking at direct gifts. It makes the WR higher and makes the SORR protection worse but looks to me the only option that doesn’t involve insurance. Total monkey wrench into the plan. Since I will have 1M in the Roth I could probably use some of that as a gift source without affecting cash flow. I hate to spend Roth money though. There may be a cheaper way to do this, have to study it. I swear retirement planning is like Brazilian Jujitsu, full contact ground fighting. So much for 4% x 25 amazing simple math.

      I went to Davids site and he has 2 interesting articles on this and here is the comment I left

      I’m thinking gifts. You can gift 15k per spouse for each kid, equaling the 60K / yr you would pay to insurance for 2 kids. Some of that can go into a kid’s Roth, some into a brokerage, over a couple decades quite a bit can be transferred and it will inflate nicely. When the bitter end comes then they will settle with the government, but smaller IRA’s will mean smaller taxes since much IRA money has already been transferred.

      The cost is a bigger WR during your life, a 100K retirement turns into a 160K retirement. The reality is the older you get the more retirement is amenable to a higher WR. At age 62 age 92 is 30 years away. At age 72 it’s only 20 years away, so a similar size nest egg can rationally be more aggressively pilfered. My retirement is spread between SS, TIRA (only a small 500K account), Brokerage with tax loss harvest, and Roth. The Roth is designated as self insurance and the rest as retirement income, so the Roth is closed to withdrawal and therefore SORR. The TIRA is designed to be a small annuity like account that throws off regularly increasing amounts based on the RMD schedule so between SS and TIRA the taxes are optimized to the 12% bracket for 15 to 20 years. If you’re 72 at RMD that takes you to 87 to 92. The TIRA is scheduled to have money till age 115 so it can be accelerated in withdrawal a little but still in the 12% (to the top of the 12%), taxes paid and the extra gifted. This would run the TIRA out of money sooner and raise the tax burden some but would get cheap money to the kids rather than to some insurance company. In the mean time thr Roth stays closed and grows unmolested. When the TIRA runs dry then the appreciated Roth is opened to take up the slack and by then you’re very old and the Roth is big so the wealth transfer can continue. Since the brokerage is not liable to SECURE shenanigans, it is transferred as property with a step up in basis so it’s dissolution can occur over decades. I guess you call that a silver lining.

      The bottom line is MAX OUT YOUR PRETAX may not be the mantra to follow. It may be equivalent to MAX OUT YOUR TAX BILL ONCE YOU CROAK. In my case I quit donating to pretax at age 50 and aggressively invested in my brokerage. I thinks this is the correct maneuver. This act throws a monkey wrench into FIRE if you’re expecting to leave some dough to the future generation and not just a big honkin tax bill

  2. Frightening prospect…I think we’ll be making the same shift to maxing out taxable going forward, as we are pretax heavy and were planning a Roth conversion all along. Time to sock away dinero to pay for the conversion as well as the living expenses while the conversion takes place. Appreciate your putting this on my radar. Like GasFIRE, I’ll need to revisit the estate plan should this legislation pass.

    1. You have to come to an understanding it’s not what you make, it’s how much you get to keep. When you buy a pretax you get married to the government, and the government means to clean your clock. When you get in bed with the government, 4×25 simple becomes damn complicated. Given the future opportunity make sure you tax loss harvest.

    1. I’m not super familiar with Cal Pers but in general public pensions are funded at about 60% of “need”. Public pensions run on buying debt and in order to make enough money in interest to cover their cash flow they tend to buy low quality debt, typically BBB rating which is one rung above Junk. Most pensions are limited in what debt they can own and BBB is the top limit. They can not own Junk. Bonds are rated by rating agencies. If you recall 2008, credit default swaps were rated by rating agencies. In those days loans were mixed into tranches and each tranche held bad debt and good debt. The rating agencies misjudged the risk of the tranches. In hind sight you could tell the crash was coming. Average people were buying McMansions 2 new cars and a new boat on a cabbies salary by floating mortgages on top of mortgages, so much debt there was no way it could be paid. There was no equity in the loans. Eventually the quality of the loans were called and AAA was found to be CCC and the market crashed. CCC debt is worth pennies on the dollar when compared to AAA debt. The cabbies lost their jobs, had no equity in the McMansions and cars so they put the keys in the mailbox and walked away. The insurance failed since trillions were owed and it actually got to only millions were left in the insurance accounts so rather than let the country go out of business the FED took these bad loans and put them on the fed balance sheets and allowed them to mature. Some of those loans that were CCC in 2008 actually recovered and became performing again so it was being able to freeze things and swapping fed credit for bad credit with the banks that kept the system from collapsing. The FED and Treasury and Congress also placed rules on the banks that basically put them in idle mode so they could not lend while these toxic debts were maturing.

      Cal Pers faces a similar problem today. They own paper that likely has mis-priced risk like banks owned mortgages with mis-priced risk. This means if the BBB actually gets priced correctly it will become junk and Cal Pers can’t own junk so it will have to sell and market forces will prevail. It’s supply and demand. If the supply dam fails a rush of bad paper will hit the market and instead of getting 50 cents on the dollar the bid will be 0.5 cents on the dollar so suddenly Cal Pers which was 60% underfunded is now 6000% underfunded, since the junk bond market can’t absorb all the bad paper. The market will freeze and no transactions will occur and nobody will be getting pension money and you will be paid in IOU’s. I used to own CA muni bonds and I sold them out exactly for this reason because I didn’t want to get paid in worthless California IOU’s. Not only is Cal Pers at risk but so is Illinois and NYC and NJ etc all of the Democrat strong holds that have been ripping off the system for decades. The assumption was the “government would bail us out” but there is no money. The federal pensions are also underwater. In the mean time corporations have been issuing stock buy backs to raise their stock prices and funding those buy backs with BBB paper which is being sold to pension funds. The market is up nearly 120% over it’s long term mean, and one thing is certain things regress to the mean eventually. 120% over means regression is a 60% drop in stock prices to get back to the mean. A $100 stock drops to $40 and once dropped there is no reason to go back to $100 since the stock was overpriced to begin with due to the financial engineering dome with 3 decades of stock buy backs and phony market manipulation.

      So if you’re counting on Cal Pers good luck with that. What you own are IOU’s on your future not real money in the bank. What you own is leverage and risk the same as every other pension fund in the country. If you own S&P 500 good luck with that. What you own are 500 companies that have been selling a mirage. If you are 100% in S&P you own 100% of a mirage and the same with any other stocks. Guess the boggleheads never told you about this with their stupid 4 x 25 nonsense.

      I don’t want to sound perversely negative and my prose are a little over the top and I intend them to be a little over the top. In 1990 The Nikkei 225 hit 37000 and crashed. 30 years later the Nikkei is 23000 and never again saw 37K. Just because US markets have traditionally gone up does not mean they are immune to Japanization. Demographically the boomers are retiring and this year there are now more boomers retired than working. Retirees spend less and therefore are a drag on GDP. Retirees consume more subsidy like SS and Medicare. Retirees pay less taxes and down size property. Retirees don’t buy new cars very often and a big slug of boomer retirees will have a boomer size effect on the economy. It’s the boomers that powered the economy the past 50 years. So the demographics are setting up to be a drag on growth also.

      That in my opinion is what we are looking at. The solution is broad diversification into non correlated assets and to not hold any single asset like “stocks” in high concentration. The solution is to own a portfolio that doesn’t need much leverage to survive the proposed length of time. So if you have a 40 year horizon and will need to make 8% to fly that airplane, your chances are much worse than the guy who needs to make 3% to make 40 years. If you have a high WR your risk is far worse than the guy with a low WR. If your time frame is 40 years you’re at more risk than the joker who has only 20 years left. If you make greater than the bottom 2 tax brackets the government considers you rich and they feel entitled to soak you. So you need to understand the tax code. This is the kind of stuff my blog has been devoted to as opposed to the happy talk mumbo jumbo narrative of the rest of the fire community. You can still plan and still succeed but there isn’t anything “easy” about planning this scenario with any degree of risk management.

      Since it’s Jan 1 HNY!!

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